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A simple quick explanation as to why US gasoline prices will continue rising rapidly

March 24th, 2008 Michael McDonough

Consumers around the world are being indirectly taxed through record high gas prices. This of course hurts consumers’ pockets and can raise inflation fears. We wanted to take a look at the crack spread between WTI crude prices and US petroleum prices as measured by the Energy Information Agency. We outline the results below.

The February reading of the U.S. all grades all formulations retail gasoline prices per gallon was $3.078 verses a WTI price of $95.35/barrel for the month. Why is this important? First off, gasoline is produced by applying a refining process to crude oil, so factoring out crude previously purchased at a lower price and hedging activities, gasoline has to be more expensive than crude. For comparative reasons we broke the WTI/barrel price into a WTI/gallon price, so we could compared it to gas prices. The results were not surprising, that is until recently. The average spread over the last 15 years of WTI to gasoline prices per gallon has been $0.53; never going below $0.25, that is until October of 2007. As you can see from the chart below the Gas/WTI spread has remained fairly constant over the years until the recent convergence. We currently estimate the spread for March 2008 stands around -$0.15 after a reading of 0 in February. What does this mean? Well it means eventually, and likely sooner rather than later, the US will experience a sharp rise in gasoline prices, at least without an offsetting drop in WTI prices. If you were to apply the historical spread to current WTI/gallon prices US gasoline prices would total $3.96/gallon. This number seems quite realistic to me.

This chart shows the spread between WTI and gas prices has collapsed, meaning WTI prices will need to experience a sharp decline or gas prices need to catch up…

Source: Energy Information Agency & my calculations

Investment Relevance: Crack spreads are used as a measurement of the profit margins for oil companies, such as XOM. In fact, recently, we have seen a drop in both the spread and XOM’s share price. If this spread reverts to its historical level, then we would expect to see higher margins, which should be reflected in share prices. However, the current zero to negative spread does not bode well for the industry, but as we mentioned above we do not imagine that will last for long. One concern however, is that there tends to be a lagging relationship between the two variables. As you can see from the chart below there does in fact appear to be a correlation between the 4 month lagged XOM price and the Gas/WTI spread. This implies that the recent drop-off in the Gas/WTI spread could place some downward pressure on XOM. However, this is a very simplistic model, and I would strongly discourage anyone from trading on it without significant refinements. There is a lot more than one variable that will affect price; this is simply meant to be a demonstration.

4-Month lagged XOM price vs, Gas/WTI spread shows that XOM stock price could face some downward pressure in the coming months

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